How Does The Stock Market React To Economic Distress?
The headlines throughout the past quarter have been filled with war, horror and pessimism-a sure sign that it is time to buy stocks. So says Gary Gray, visiting professor of finance in Penn State's Smeal College of Business.
UNIVERSITY PARK, PA--The headlines throughout the past quarter have been filled with war, horror and pessimism-a sure sign that it is time to buy stocks. So says Gary Gray, visiting professor of finance in Penn State's Smeal College of Business.
"With so much uncertainty and bleak news regarding the economy and the geopolitical scene, why would anyone want to buy stocks? Because recent history has shown that when the economy is in turmoil and pessimism is highest, those who invest in stocks receive above-average stock market returns," says Gray.
He notes, for example, that over the period of 1926-1999, the Stocks Bonds Bills Inflation (SBBI) Yearbook shows yearly inflation-adjusted returns for large company stocks in the U.S. The average annual return for that 74-year period is 9.8%. Gray defines the Depression and the four war-related sub-periods as causes of "economic distress" to show the stock market performed during those pre-event and event periods:
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Average
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Average
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Event
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Pre-Event
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Ann. Ret
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Event
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Ann. Ret.
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| Depression | 1929-30 | -14.3% | 1931-35 | 11.6% |
| World War II | 1940-41 | -15.0% | 1942-45 | 20.7% |
| Korean War | 1948-49 | 11.3% | 1950-52 | 19.6% |
| Viet Nam War | 1960-62 | 5.0% | 1963-72 | 6.0% |
| Persian Gulf War | 1990 | -8.7% | 1991 | 26.7% |
Why this pattern of returns? The stock market anticipates events and dislikes uncertainty, says Gray, who is co-author of the book, The StreetSmart Guide to Valuing a Stock (McGraw-Hill). He explains that during the pre-event periods, uncertainty about the eventual outcome of the event is at its highest. To purchase risky stock investments in uncertain times, investors require a higher expected rate of return thereby driving down prices. As the event becomes understood and the potential outcomes appear less dire, the risk premium of stocks and the required rate of return declines and stock prices rise.
"Stock prices reflect the war of public opinion. Optimistic investors bid up prices sometimes beyond reason, such as during the Internet bubble. Due to overly pessimistic forecasts, investors may sell or shun stocks-also sometimes beyond reason, such as during the Depression," says Gray.
"My optimistic view of our war on terrorism in these pessimistic
times is that the bad guys will lose and the good guys eventually will
win out, and many of us will be kicking ourselves because we overlooked
an opportunity to buy great companies at bargain prices," says Gray.
